Watch stocks you care about

Return on invested capital is one of my very favorite metrics. In this article, I'll show how you can use it to find stocks to buy, stocks to watch, and stocks to avoid, starting with Taseko Mines (AMEX: TGB) , and discussing competitors Southern Copper (NYSE: SCCO) , Freeport-McMoRan (NYSE: FCX) , Teck Resources (NYSE: TCK) , and Newmont Mining (NYSE: NEM) .

Beware ROEYou've probably heard of return on equity, a favorite of Warren Buffett. It measures net income (the "return") relative to the equity capital a business has raised and built. A higher ROE signals a more efficient business.

But ROE can be gamed. Because debt is cheaper than equity financing, a management team whose bonuses depend on ROE targets may be tempted to lever up, increasing risk, just to juice net income and ROE.

Return on invested capital -- which is like a return on debt and equity -- catches this. ("RODE" would have been a catchy acronym, no?) To find ROIC, simply divide a company's after-tax operating profit by the sum of its debt and equity. Because it includes debt, ROIC is harder to fudge than ROE. Studies also indicate that watching ROIC can improve your returns.

Why ROIC reigns supremeMichael Mauboussin -- the chief smart dude at Legg Mason Capital Management -- divided stocks into quintiles by ROIC in 1997, then tracked them through 2006. The lowest 1997 quintile ended up performing worst, unsurprisingly. But the stocks with the highest starting ROIC didn't perform the best, with annual returns of less than 6%, mainly because they fell out of the top quintile along the way.

Two investing secrets emerge from the nuances of Mauboussin's findings:

1. If you find a rising ROIC, you could have a winner.Companies that started 1997 in the lowest or second-lowest ROIC buckets, but finished 2006 in the highest or second-highest, delivered returns of 14% annually.

2. While a high ROIC alone doesn't help, consistently high ROIC is a marker of outperformance.Companies that started in the No. 1 or No. 2 quintile in 1997, and remained there through 2006, delivered a whopping 11% annually.

Will our next contestant come on down?Let's see how Taseko Mines, a Canadian copper mining company, stacks up by this measurement. We'll be using numbers from Capital IQ (a division of Standard & Poor's). For most moderate-risk companies, I consider anything greater than 9% to be a decent ROIC; more than 12% is even better. The higher the risk, the higher the ROIC you'll need to be content.

ROIC for Taseko Mines

2006

2007

2008

2009

TTM

25.7%

31%

10.7%

5.6%

5.8%

What can we conclude? Taseko has very volatile results; they sport a standard deviation of 12 percentage points. So goes the commodity business. But copper prices bottomed at the end of 2008 and have rebounded to roughly where they were in the few years before they crashed, although if the global recovery stalls -- especially in China -- that rebound will ease.

Of course, Taseko isn't the only mining company in town. Southern Copper operates in low-cost Peru and sports trailing ROICs ranging from around 20% to around 40% -- a clip above Taseko's. The big copper daddy is Freeport-McMoRan, which is a bit more levered than Southern and Taseko, but which delivers still-higher ROICs and tends to operate in more stable regimes than some other global producers. Fellow Canadian Teck Resources just unloaded a lot of its gold mining to focus on shoring up its finances through its more diversified portfolio, which includes copper and metallurgical coal. Its ROIC has declined from 29% in 2006 to 7.2% most recently. And a more distant competitor sporting copper and gold -- mostly gold -- is Newmont Mining, which, thanks to rising gold prices, has seen its ROIC rise from 6% five years ago to 15% today. Its stock is up 43% over the past year, and it just increased its dividend by 50% (music to my dividend-loving ears), but will gold prices keep rising?

In the end, as I'm sure you know, for Taseko it comes down to where copper goes from here. A safety-focused ROIC investor might wait for a positive trend to emerge, whereas a risk-tolerant one might see greater upside from guessing when a trend is about to star.

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I agree that ROIC is can be a very useful metric... However, it should never be taken as the only measure of value as was done in this case. The big opportunity with Taseko (TGB) is the new mine that will open in Canada (after years of enironmental reviews/studies, etc). ROIC has no meaning when judging the value of a yet-to-be producing asset... All metrics (good and bad) rely strongly on the context in which they are being used!

With respect, ROIC may be harder to fudge, but I have watched companies (e.g., Agilent Technologies) get rid of hard assets for pennies on the dollar just to lower the denominator in ROIC during a bad revenue year. This should be noticeable in Book Value or other metrics (if not for good will), but I have never seen any analyst comment on this fairly common practice.